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Jim Miller is president of PharmSource Information Services, Inc., and publisher of Bio/Pharmaceutical Outsourcing Report.
Some recent private-equity buyouts of CROs show both the upside and downside for investors.
The year 2011 ended with the buyout of the contract research organization (CRO) Pharmaceutical Product Development (PPD) by two private-equity firms, the Carlyle Group and Hellman & Friedman. They paid $3.9 billion, a 30% premium over the company's value shortly before the deal was announced, making it the largest private-equity deal for a publicly traded CRO.
Clinical CROs such as PPD have proven to be popular takeover targets for private-equity firms: PharmSource counts at least eight publicly owned CROs that have been taken private by private-equity firms since 2003 (see Table I). One CRO, PRA International, had a roundtrip. It was founded as a private company, taken public by its private-equity investor, Genstar Capital, in an initial public offering (IPO) in 2005, and then taken private again by Genstar in 2007.
Table I: Publicly traded contract research organizations acquired via private-equity deals.
Private-equity buyouts are usually quite attractive to the current shareholders of the company because they offer a significant premium over what the company's stock was selling for shortly before the deal was announced. These deals are usually even more enticing to the senior executives who run the acquired company for two big reasons. Going private allows executives to pursue long-term growth strategies away from the oversight of public shareholders and Wall Street analysts, both of which may be more interested in short-term results than initiatives that promise longer-term, but more uncertain, payoffs. As importantly, the private-equity buyers usually offer the senior executives increased equity stakes in the company that can deliver great riches if those executives are successful in substantially increasing the value of the company through the successful implementation of those long-term strategies.
The PPD deal illustrates how senior management's frustrations with the public market can drive a company's board to pursue a private-equity buyout. In the past decade, the company had pursued a strategy it called "compound partnering" under which it would acquire or invest in promising early-stage drug candidates. PPD would undertake the early-development efforts to establish proof-of-concept, then out-license or sell the candidate to a drug company for late development and commercialization. Despite some early successes, the stock market and analysts following the company were uncomfortable with this strategy because it introduced a level of risk and uncertainty into a valuation model that expected steady financial performance that was easy to forecast. As a result of the uncertainty, the market discounted the value of the company's stock. A similar problem had been a major reason for another CRO, Quintiles, to undertake a management-led buyout in 2003.
PPD's board tried to improve its stock's performance by making its compound-partnering business into a separate company, which it spun off to shareholders in 2010. That move, however, did not help the stock's valuation as much as had been hoped. Part of the problem had been the underperformance of PPD's laboratory services business, whose disappointing profitability in recent years has been blamed for depressing the company's stock price.
Private ownership may enable PPD management to address the laboratory businesses' problems with a long-term view while shielding it from second-guessing by public investors. That was the story at PharmaNet Development, which was bought by a private-equity firm after it was cited for noncompliant behavior in running some of its clinical trials.
The aim of private-equity investors is simple: make a large cash return on the cash invested. This goal is accomplished in two ways: by taking advantage of the acquired company's cash-generating capability and by making the company worth more when it is sold than when it was bought.
Most private-equity deals take advantage of the acquired company's ability to support a significant debt burden. By using the target's debt capacity, the private firm is able to borrow much of the purchase price and limit the amount of cash it must put up to make the acquisition in the first place. Current interest rates make borrowing especially attractive.
Clinical CROs are an attractive vehicle for leveraged buyouts. Their capital-investment requirements are usually small in comparison with manufacturing businesses, so they can throw off a lot of cash. Further, those cashflows are highly predictable because clinical CROs tend to have highly diversified multiyear project backlogs. A growing CRO is likely to be able to pay out substantial dividends to its owners as well as carry a substantial debt burden.
Enhancing the value of the acquired company may just be a matter of timing, such as by buying the company at a low point in the market cycle and going public when market multiples are high again. The private-equity firm also can improve the value of its target through further acquisitions, expansions of offerings, or restructuring to improve profits. Stock analysts who were following PPD before the acquisition speculated that PPD's laboratory businesses might be in for restructuring.
Buyouts by private-equity companies are not without risk, as such moves are subject to not fully understanding the prospects of the business or changing market conditions. Both of these things appeared to happen to the buyers of the European CMO Nextpharma, whose Belgian injectables manufacturing business was recently forced to file for bankruptcy protection, as well as to the French CMO Osny Pharma, which filed for bankruptcy protection in early 2011 and was absorbed by another CMO, Cenexi.
While PPD's track record of profitability and market position (it is thought to be the second largest for Phase I–IV clinical research after Quintiles) would seem to guarantee a strong performance over the typical private-equity holding period of five years, the changing CRO and bio/pharmaceutical research environment could present challenges. As global bio/pharmaceutical companies reduce their CRO relationships to a few preferred providers, competition for those relationships has become intense. There reportedly has been aggressive price cutting in the industry to get those deals, thereby leaving "winners" saddled with lower profit margins but losers shut out altogether.
Investors have been attracted to the CRO industry because the ongoing reinvention of the bio/pharma business model has outsourcing as a core strategy. The ultimate form of that business model is still evolving and being tested, and there is no guarantee that it will ultimately look like what it looks like today. Buyers of PPD bought one of the crown jewels of the industry. The greater risk is probably faced not by them, but the private-equity firms that bought PPD's small and mid-size competitors.
Jim Miller is president of PharmSource Information Services Inc., and publisher of Bio/Pharmaceutical Outsourcing Report, tel. 703.383.4903, fax 703.383.4905, email@example.com, www.pharmsource.com